CFA Level 1 (2009) - 3
.pdfSdf:JC5t: financial Reponing and Analysis
SELF-TEST ANSWERS: FINANCIAL REpORTING AND |
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l.H The MD&A is required I<l conlain informalion on lrends in sales and expel1S<.:S, <.:xpened capilal expendifll),(:s and orher events affecting liquidity, and the outlook fiH the fUlure
based on known lrends. Delails of depreciarion methods arc conrained in the fOlllnolc5
to lhe financial SlalemenlS.
2.C The p<.:rcentage-of-complelion method recognizes a proporrion of estimared projeCl profirs, which will increase ner income, rerained earnings, and equiry and aS5US relaliv<.:
10 the completed contract /11nhod. With inerea5ed equiry and aS5etS, bOlh the delHI asselS and debl/equilY ratios are c1<.:creilsed. Cash How.s ;11<.: IlnaCfecled by the l11er!llld seleued (l) account I'llI' lhe project on the financial SLllcmeIllS.
:I. B IntCfest paid i.1 an operaling cash How, and dividends paid arc a financing cash flow, so rhc firm thal pays highn dividends will haw JOWl'!' CFF. The Iirm wilh lo\\er ltllncst l'Xpcnsc will han' Ilighn L1'S.
ii.i\ Inventorv lurIlllvn involvcs sales (from the incol11e 5Ial<.:meI1l) and averagc invclllory
(1'1'0/11 the balance 5hcl'l) so il cannot be calculaled from cOJl1l11on-size SlalemelllS. Debr
(() equiry is ddn/assets divided hy equity/assets. Operating profitslsalcs can bc read directly from the cOIII/11on-size income sratement.
'i. A Ca.\h conversion cycle = c"llection period + invmlory period - payahles pni"d.
An increase in invenlory tmnover will decrease lhe inventory period ~nd shorten the cash conversion cycle. An incrc~s<.: in the payables period will ~Iso shorten the cash conversion cycle.
(). C Famous, Inc.'s sustainable growlh ratc = (retenrion rate)(ROE).
ROE = 0.20(800,000) / [(ROO,OOO/OS)(J 116)] = 160,OOO!l ,000,000 = 16%.
Alternatively:
ROF = (0.20)(0.SO)(I.Gl = 0.16 = 16(Yo
RerelHion rate = (J - Dividend Payour Rario) = 1 - {32,OOO/[(0.20)(800,000)JJ = 0.80.
Sustainable growlh = 0.80 (1 Mil) = 12.8%.
7.A Based on rhe average stock price, only the options at 18 arc in the money (and therefore
dilutive). Using the rreasury stock merhod, rhe average shares outstanding for calculating diluted EPS would increase by [(20 - 18)120] 200,000 = 20,000 shares.
8.C UFO reserves are nor amorri7ed. A decline in rhe LIrO rcserve occurs when the increasing prices that creared the reserve begin declining or whcn invenrory is liquidated (i.c., fewer unirs in inventory at rhe cnd of rhe year lhan at the beginning).
9.A With convcrrible bonds, the procceds at issuance represenr a balance sheer liability. For a bond with warrants artached, the fair market value of the warrants is recorded as equity, and rhe remainder of the proceeds is recorded as a liabilily, so liabilities to assets and liabililies to equity are both lower (improved), With interest expense the same on borh issues, there is no effect on ncr income or ROA.
Page 340 |
©2008 Kaplan Schweser |
ScH~Tesl: financial Repofling and Analysis
10.C If the COSl were allloni/.ed rarher lhan expensed, rhe $H IIIillion cosr of rhe franchise would be classilieJ as an invesling cash flow ralher lhan ,In operaling cash Bow, so eFO would increase (and CFl decrease). The asser created by capiralizing lhe COSl would increase assns, so the dehr·lo·assets rario would decrease.
11.B If it becoIlles probahle that a ponion of a deferred lax asser will not llC realized, 'I valuarion allowance should he esrablished. A valuarion allowance serves to reduce the value of a deferred lax assel 1'01' rhe probability Ihar ir will nOl be re'llized (lhe dirkrClllt' Iwrwcen lax payable and income lax expense will not reverse in fUlure periods).
l2. C Invesling cash !lows were IIIuch highellhan opnaring cash flows for Enron, indicaring a need for a grear deal of financing. The olher lWO choices were bOlh warning signs relaled
10 lhe Sunbeam accounring scandal.
U. C \1(!ilh a finance lease, only the illleresr portion of the lease paymenr is classified as CFO, so CFO will be grealCl' than ir would be wirh an <,<]uivalem olKrating lease. CTF will be less ror a finance lease because rhe principal portion or each lease paymull is classified as 'I financing cash oud1ow. Operaling income, EBIT, will 11<' reduced only hy lhe (equal) anllual depreciarion expense wilh a financ<' kase, so opeLlIing il1Col1le williX' 1',IC'11<,1 1'01 a finance kase rhan for an 0l'naling lease (Ic)r which the emire 1<:'1 St' payment will be an operaling expense). Al inceplion, a finance lease will increase 'lssers and liabilities bv rhe same amounr so rhere is no effecr on equity.
14. B Al asscr acquisirion, a liahiliry equal to rhe presel1l value of rhe asser disposal cosrs is created and an asser of equal value is created, so lhere is no initial cJ'fecr on equil),. The increase in the liabililY (accrerion) each year is recorded 'IS inrerest eXpl.'l1Se, so il1lt'l"esl coverage rarios are lower each year when rhere are assel disposal COSlS. Wilh aSSl.'r disposal cosrs, ncr income will be reduced each year by both the inreresr expense on lhe liabiliry and by depreciarion of the offselling assel lhat is creatl.'d.
1'i. C Impairmenr charges reduce operating income and Ilet income in Ihe pniod ofrhe charge. Taxes are not affected because any loss in asset value will reduce taxes Dill)' when lhe ,ISSe\ is disposed of and rhe loss is actually reali/.ed. The dehr lO equilY ratio increases in the period of the charge because equity is reduced.
16. B Il1leresr on loans rhar specifically fund construction of long·lived assers musr be capiralil.ed under U.S. GAAP. Assets of insignifical1l value (e.g., Illeral waSil' hasket) alt' lypically expensed even when their useful lives arc many years. R&D cosrs ;ue expen~c<1 under U.S. GAAP.
17. B There are no effects on invesling cash flows from the exercise of employee srock opriol1s. Oprion exercise resulrs in a rax deducrion that reduces raxes and increases opera ring cash flow. Since employee incentive slOck options are properly parr of compensarion
expense, cash expenditures ro repurchase shares and avoid dilution are properly classified as operating cash flows rather than as financing cash flows (their classification under accoulHil1g stanclards).
18.C \Virh falling prices, FIfO inventory accounting will result in higher COCS, lower ner income, and higher cash How because of lower taxes on rhe lower ner Income.
19.C Annual depreciation is .370,000 - 340,000 ~30,000.
Average depreciable life is gross fixed assEts/anl1ual depreciation ~
(400,000 + 370,000)/30,000 ~ 25.66 years.
©2008 Kaplan Schweser |
Page 341 |
Self-Test: Financial Reporting and Analysis
20. A The receipt of the tax-exempl interest income will create a pernnnc'nt difference between pretax incollle and taxable income. Since the tax-free in!ere~ increases pre-tax income, hut nOl income tax expense, the effeclive lax rale will be less lhan 40%. No deferred tax li,thility is crcl[ed because the dillcrence belween prelax and Ltxabk income willnevcr reverse .
.J I. C The analyst should treal the "sale" of receivables as a loan secure'll hy l he receivalllcs. 'Chis Illeans the receivables should he added back lO accoul1ls receivable, decreasin!!, receivables turnover. A current liJ.bility elJualto the value of the loan should be added to the balance sheel, which will increase the l(llal debl ratio. The cash received remains on the balance sheer so there is no reduction in the value of cash and markelable securities.
22. C Foreign issul'l's in U.S. markels must either submil U.S. GAAP complianl financial statemellls or separalely provide a reconcilialion of their lFRS slatements with U.S. GAAP, including relaled disclosures that will :lid financial Slatemenr users in the Uniled Slates.
25.C Unrcalizcd gains and losscs on tr:lding sccurities arc rq)()!"lcJ ill the inlollle ,1:llClllCJll undn hOlh U.S. allllll'!{S sl:lIldards. Siucc UFO is nO[ permitLl'd under ll-RS, adJusling the invenlory amoulll for a LIFO firm is a likely adjusllllelH. -1,) aCCllUlll ror dilTerences in how companies report leascs, adding the IHeSCIH v:Jiuc of futlll'c minimum operaling lease paymcl1ls lO bOlh the aSSClS and liabilities of a linn will removc lhe dfeCls of lease reponing methods from solvency and leverage ralios.
24.A By convening a cash flow slatement to the direcr method, an analyst can vic\\' CJsh expenses and receipts by calegory, which will facilitare a comparisoll of two firms' cash outlays and receipts. eFO is correct under either method and requires no adjustmellt. Neither dividends received nor dividends paid arc classified as eFl under U.S. GAAP
Page 342 |
©2008 Kaplan Schweser |
FORMULAS
Activity Ratios:
annual sales
receivahlcs IUrIlUVLT
average reccivahlcs
.'36')
days of sakos ()usL1l1ding=
rl'lTiv;lhlcs turnover
(ost of goods suld II1VCl](ury lurnovcr=c -
average IJ1vellwry
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II1Vc'ntory lUrnUVLT |
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purchases |
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payables turIlover |
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average track p;ly:lblcs |
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number of days of payables .", |
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p;lyahlcs turnover ratio |
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IOlal |
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reven uc |
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assel ! UI'I10V"T |
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avcrage total asscts |
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fixed |
asset t urnovcr |
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ITvcnuc |
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average net fixed assets
reven ue average working capital
Liquidity Ratios:
current assets clIrrcnt ratIo =--= ------
current liabil itics
quick r:nio c=, cas~+ ~arketablc_~_e~lI!i~es + receiva.?I(~.s
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curren t Iia bi1ities |
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cash |
+ marketable securities |
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cash rallO |
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current liabilities |
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e" |
I. cash -I- marketable securities + receivables |
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CICITnSIVC llllerva |
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average daily expenditures |
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(days sales |
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[days of inventory] |
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casI1 convcrsloll eye e = |
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on hand |
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oUlstandrng |
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(number_ of days J" ofpayables
©2008 Kaplan Schweser |
Page 340, |
Book .1 .~ Financial SLllcI11CJl[ Analysis
Formulas
Solvency Ratios:
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(O[al debt |
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debt~lO~eqllity'-- .. -~--------- --- |
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[olal shareholders' equity |
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debt-lOcapiral . |
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total dell! |
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tmal debt \- lOtal shareholders' equity |
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(Otal debt |
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lOtal |
assets |
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average (Otal assets |
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IlI1anciallcveragc = -------- |
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avnage (Otal equilY |
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~'_~~~1inQ~J)lJ(~'ei~1terest and taxes |
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IIItcrest paYlncnts |
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fixed charge coverage |
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earnings before interest and taxes -Ilcase payments |
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interest payl11l'IHS -I- lease payments |
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Profitability Ratios: |
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net profit margin |
net Income |
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revenue |
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gross profl t margi 11 |
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gross profIt |
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revenue |
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operaul1g Income |
EBIT |
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operating profit margIn = |
or |
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revenue |
revenue |
FlU
pretax marglll
revenue
return 011 assets (ROA) =
return on assets (J'Z()A) =
operaung return on assets
return 011 total capital ~
net lJ1come
------~ average total assets
net income - I - interest expense (l - tax rate) |
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average total assets |
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operaung Income |
EBIT |
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or |
average total assets |
average total assets |
EBIT
average total capital
net Income
return on equIty ~
average total equity
Page 344 |
©2008 Kaplan Schweser |
Book 3 - Financial Statemcnt Analysis
Formulas
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nct income -. prckrred dividends |
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relurn on common c'1uIly ,~: |
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avnagc common CqllllY
net income availahle to common average common e<.lllIly
Free Cash now to the Finn:
FeF F = nee income + noncash charges + [inrcrest expense x (I - tax rate) 1 - fixed capital invcstmel1\ - working capital investment
j;CFF cc cash How from operations + [intcrest expense x (1 - tax ratc)1 - fixed capital Investment
Free Cash Flow to Equity:
j:Cj:E = c.lsh flow I"rom operations - fixed capital invesllnent + nct bOlTowing
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Income statclllclH accounc |
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COI11l110n-Sli.C Income SLltement rauos = |
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sales |
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COlllmon-Slze |
)a ance s 1Cl'l rauos |
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lOcal assCls |
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common-size cash How ratios cc |
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cash flow scatement account |
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reven ues |
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.. |
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ROE = |
[net !Jfofit] [ |
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asset ] [Ieverane] |
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onglna |
DuPont cquauon: |
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margm |
turnover |
ratIO |
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extended DuPonr equation: |
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ROE = (net incomeJ[ EBT J[_E.~J[ |
revenue |
J[ total assets ] |
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EBT |
EBIT |
revenue |
IOta] assets |
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EPS |
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net income - |
preferred dividends |
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weighted average number of common shares outstanding |
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net income - |
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debt |
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diluted |
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dividends |
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dividends |
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mterest |
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EPS |
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weighted |
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shares From |
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conversion of |
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issuable From |
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shares |
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conv. debt |
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stock options |
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©2008 Kaplan Schwcser |
Page 345 |
Book :3 -- Financial SI'lll'nlClll Analy,is
Formulas
Coefficients of Variation:
standard dcviariol1 of sales
(:V sales
Illean sales
sLlI1dard dcviation o( Opn-llJl1g IIKUI11C
(:V opcraril1g incol11e |
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lllean opn'lllllg II1c0l11l'
st'll1dard deviation of net incol11e
CY ncr income
meal1 ncr lI1COl11e
Inventories:
ending inventory .- hcginning il1vcntory + !lurclLlsl'S -- (:OCS
CUrrCl1l cml o(invl:l1l01"\' 1,1:1j:()) ~ J.lH) ill\l'lllOl\' 1 I.IJ:() rl'SlI"\'C
COGS FIFO = COCS [\1'0 - (ending UFO reserve - beginning L1H) reserve)
LongLived Assets:
cost - salv3ge value
straight-lint' depreciation = - |
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llseful life |
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(cost - :lcCUl11lJlatcd depreciation) |
l. useful Ide |
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average age III years = accumulated depreciarion annual depreciation expense
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accuffiulared depreciation |
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average age as a percentage = . |
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endll1g gross IllVeSll11ent |
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average depreciable life = |
ending gross investment |
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annual depreciation expense |
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remaining useful life ~ |
ending net investment |
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annual depreciation expense |
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Deferred Taxes: |
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income tax expense = taxes payable + ~DTL - |
~DTA |
Page 346 |
©2008 Kaplan Schweser |
Book.) - Financial S[.llCIllCIH AILdysis
hlrmlilas
Debt Liabilities: |
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_=[lhe IIIa~-kCl |
ralel x |
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the balance sheCl value |
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Intcrest eXpL'l\SC |
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of till'liahililY :ll |
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at Issue |
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Ihe beginning oflhe pcriod |
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Perfi.Hmance Ratios |
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Cash tlow-to-revenue :=.: ----- |
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nel reven LIe |
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(~ash rerllm-on-asselS |
c:ro |
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average IOtal assets |
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C:l.,h retum-on-equiry |
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C:FO |
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average IOlalnjllil\- |
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ern |
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(:a.,h-IO-inconw ::- ----- |
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operating incomc |
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|
ero .- prcferred dividends |
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Cash Do\\'per share = ----------------------------------- |
|||||||||
|
weightcd avt:rage nlll1lbL'r or COIllIIIO!l shares |
||||||||
Coverage Ratios |
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|
eFO |
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||
Dchr coverage -- ---- |
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|||
|
IOral deb[ |
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||
|
CFO + interest paid + l:lXes I)aid |
||||||||
lnteres[ coverage =-=- |
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|
|
----------- |
|
in Icrest paid
CFO
Rl'i!l vcstmen I
cash paid For long-term :lSSl'lS
Debr payment = |
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|
eFO |
|
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|
cash long-term debt repayment |
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||||
, 'd d |
payment = |
-- |
cro |
|
||
0. IVI en |
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|||
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|
dividends paid |
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||
' |
d~ |
, |
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|
CFO |
InvestIllg an I 111 an Clllg = |
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|
cash outflows from investing and flnancing activities
©2008 Kaplan Schweser |
Page 347 |
INDEX
A
;lccc!natni depreciation 'S6, 'SR, 175 account formar RH
accouIlling eyuation 12 accounrs 2\
accounts payable 91
accrual accounring 23,39, 50 accrued <:Xllc:mes (liabililies) 24, l) 1 ;lccruc:d rcvenuc 23
accumulaled orh<.:r comprehcnsive inull1lc lJ? aClivilY rarios 260, 261
;ldjuslcd trial bahnce 27 a,h'nsc opinion 1/1 amoJ"[ i/.alion 61, \78 antidilurivlO securiries 6(l
aSSlOl rlOtirlOmcnl obligarions (ARU) 179 assers 12,21,86
:lu,Jir 13
audiwr's opinion 14 authorizcd sharlOs 96
available-far-sale securilies 95, 523 average aglO 177
avnaglO depreciable life 177
B
balance sheet 12, 87 |
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||
bal:lncc shect ralios 98 |
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||
bargain purchase option 235 |
|
||
barrer transaction |
54 |
|
|
basic accounting equ~}[ion 22 |
|
||
basic EPS (14 |
|
|
|
bond, b:dance sheet liability 223 |
|
||
book value |
173,223 |
|
|
business risk |
281 |
|
|
busincss segment |
282 |
|
|
c |
|
|
|
capital adequacy |
281 |
|
|
capitalized interest 165, 328 |
|
||
capital lease |
235 |
|
|
carrying value 173,196,197,223 |
|
||
cash conversion cycle 264 |
|
||
cash Aow earnings index 299 |
|
||
cash Aow from financing aerivities (CIT) |
12, |
||
J 10,116,121,125 |
|
||
cash Aow from investing acrivities (CFI) |
12, |
||
1]0,116,121,125 |
|
||
cash How from operating activities (CFO) |
12, |
110, |
11 '1, |
124 |
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|
|
|
|
||
cash flow manipulation |
:;OH |
|
|
|
||||||
cash flow pershare |
127 |
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|
|
|
|||||
cash flow SlallOmen l |
12, 10') |
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|
|
||||||
cash How-to-revenue ratio |
127 |
|
|
|||||||
cash ralio 99, 264 |
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|
|||
cash remrn-on-aSSClS r:ll io |
127 |
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|
|||||||
cash relurn-on-equity ralio |
127 |
|
||||||||
cash-ro-incomc ratio |
127 |
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|||||
ch,lngc in accounring cSlimale |
(l5 |
|
||||||||
change in accounting principle |
63 |
|
||||||||
chan of accounlS |
21 |
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|||
chssificd b:llance shccl |
HH |
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|
||||||
codlici,'nl of vari;trion |
2R I |
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|
||||||
COl11mon-sizc balance shcels |
lJ7 |
|
||||||||
common-sizc cash flow SlalemCIH |
12') |
|||||||||
common-size income stalement 72 |
||||||||||
common-size StalemelHS |
2'1'1 |
|
|
|||||||
compllOled-contract mcthod |
51, 32R |
|||||||||
complex capital SlrUctUre |
64 |
|
|
|||||||
comprehensive income |
7'1 |
|
|
|
||||||
consolidation |
L11ethod |
|
.125 |
|
|
|
||||
construction interest |
32R |
|
|
|
|
|||||
contra accounts |
21 |
|
|
|
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|
|
|
||
cOlltrihlllCd capital |
96 |
|
|
|
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|
||||
converciblc bonds |
233 |
|
|
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|
|||||
COSt of goods sold (COC;S) |
'i9, 140, 149, 32R |
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cost recovery method |
|
'S3 |
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||||
coupon paymelHs |
222 |
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|
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|||||
coupon rate |
222 |
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|
covenants 231 |
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||
coverage ralios 12R |
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|
||||
credit analysis |
2R2 |
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||
credit quality |
316 |
|
|
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|
||
current assets |
88 |
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|
current liabilities |
88 |
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|
|||
current portion of long-term debt |
91 |
|||||||||
current ratio |
98,263 |
|
|
|
|
|
|
D
days of inven tory on hand |
149, 262 |
|
days of sales outstanding |
261 |
|
days' sales in payables 30H |
||
debt covenants 231 |
|
|
debt coverage ratio |
128 |
|
debt payment ratio |
12R |
|
debt-to-assets ratio |
265 |
|
deDt-w-capital ratio |
265 |
|
debt-tn-equity ratio |
99, 265 |
Page 348 |
©2008 Kaplan Schweser |
,/~'~:Iining balancc method 5H
dd'cnsivc imcrvcd 264
tkft.ITed lax assel> 19(;, 197
dckrred tax liabilities 171J, It)6
tlL-prl.'ci'lhlc lives |
17G |
|
|
|||
d"l'l'eciatiun |
'i(;, |
17.3, 2(l7, ,)28 |
|
|||
diluted |
EllS |
()(), (,H |
|
|
||
dilillivc |
securitil.'s |
66 |
|
|
||
tlirecr /Illancing kJSL' 2/]2 |
|
|||||
direct method |
112, 115 |
|
|
|||
discl1ntinued oper'llion 61 |
|
|||||
discount bond |
22,1 |
|
|
|||
dividend, ush-flow cLlS5iticllion |
329 |
|||||
dividend payment rJtio |
12H |
|
||||
d ividmds, cash flow classi {iution |
110, III |
|||||
doublL--deciining bJlancl.' llletllOd |
'18, 171J |
|||||
,!oublc·-enrryaccounting |
23 |
|
||||
[)uI'Ol1t |
sySlt'l1l |
27/1 |
|
|
E
e:llllings I",("re interest, taxes, depreciarion, ,md 'lnlOnizJtion (EBlTDA) 267
eunings per share (EPS) 64, 278 EBIT margin 277
economic depreciation 17.3 crfective interest rJte method 221J effective rax rare 204
effective rax rate reconciliation 209
Enron aCCOlln ting sCJmbJ 300 equit)" lIlethud .325
exchanges of long-lived assets 182 expanded accounting equJtion 22 expenses 12, 22, 49
extended DuPonr equation 276 extraordinary i rems 62, 329
F
face value 222 fair value 89 finance lease 235
Financial Accounting Standards Board 35 financial assets 94
financial leverage rJtio 99,265 financialliabiJi ties 94
financial reponing 11
Financial Services Authurity 36 financial statement analysis 11
financial staternellt analysis framework 15 flnancial statemcnt clements 21
financial statelDent notes 12 financing activi tics 20 financing cash flows 12
first in, first out (FIFO) 56,59,144 fixed asset turnover 263
Book j - Fif:l" ',d :<lal,'mciil Analysis
Index
fixed charge COVL'LlgL' ratio 2G()
footnotes I 2
fraud triangle 2')') frec cash [low I ~l'
frec Lash tlow to l.'tjuity (H:l:[':J 127
(ree clsh How to the firm (FCFF) !2()
G
g'Ul1S |
12, 1J9 |
|
|
|
|
general journJI |
27 |
|
|
||
gc:ncr'll ledger |
27 |
|
|
|
|
geographic segmell! 282 |
|
||||
l',oing concnn asslIllIl'llon |
jlJ,,)') |
||||
goudwill ')2,171, 32(, |
|
||||
gross I'm/It 50 |
|
|
|
|
|
gro~s |
profir 111Jrgin |
74,2(;7 |
|||
gross fL'Vl.'nUC reporting ')(j |
|
||||
;'l"Owlh ill S:lIlIC-S[OfT s.lin |
.1.H I |
||||
'"' |
|
|
|
|
|
H |
|
|
|
|
|
held-/l)r-trading securities |
32.3 |
||||
held-tu-mJturity sccurities |
95, .322 |
||||
historical cost |
89, IT) |
|
|||
identiflable inrJngible J~set |
')2 |
||||
IFRS framework |
37 |
|
|||
impairmcll! 182 |
|
|
|
||
incollle statcmelll |
|
11, 'IH |
|
||
income tax expense |
196 |
|
|||
indircct mcthod |
J 12 |
|
|||
initial |
trial balance |
27 |
|
in-process research and development (J PR&D)
172
installment method '),J installment s,lie 53
intangible assets 57,61,92,171,327 intercorporate investments 325 interest burden 277
interest, cash flow classificarion 110, 111, 329 interest coverage ratio 128, 266
internal controls 14
International Accounting Standards Board 35
International Organization of SeclIfities
Commissions 36
inventory 56, 90, 324
inventory accounting methods 59, Ho inventory turnover 149, 262
inventory valuation method 140 investing activities 20
investing and financing ratio 128 investing cash flows 12
issued shares 96
©2008 Kaplan Schweser |
Page 349 |
~.